Back before the federal estate tax exemption was $5 million (inflation-adjusted to $5.34 million), estate planning attorneys and their clients were focused on sheltering wealth from the death tax. Now, with that fear lessened by the increased exemption, the focus has shifted to income tax planning for many.
Is it time to tweak your IDGT or GRAT planning?
Intentionally defective grantor trusts ("IDGTs") have become very popular in estate planning because they allow the grantor to move assets out of his or her taxable estate.
This lowers the potential estate taxes of the grantor, while the grantor remains responsible for the income taxes.
Consequently, the income tax burden is not transferred to heirs, just the tax-advantaged value of the assets themselves.
However, a recent article in The Wall Street Journal, titled "Rethinking Some Grantor Trusts," says the latest bull market created potentially substantial taxable gains for individuals—and with the top federal rate on long-term capital gains at nearly 24%, as compared to 15% in 2012—there is a growing concern that some people may have a harder time paying that income-tax bill.
In short, increasing income tax rates make it more expensive for a grantor to maintain the grantor trust status of a trust they have set up.
One way around this is a clause that allows grantors to essentially turn off the grantor status of the trust. This means the trust must pay its own income taxes going forward.
Note: This election can only be made once—the grantor cannot simply switch back and forth from paying to not paying the income taxes—so there needs to be some careful consideration of this decision.
Higher income taxes have prompted some to take a closer look at the assets held in grantor-retained annuity trusts ("GRATs"), which allow individuals to push some of an asset’s future profits to heirs free of gift or estate tax. Most of this planning revolves around the “step-up” in cost basis, which helps eliminate the long-term capital-gains tax on assets held until death by raising the owner’s cost basis for these assets to the full market value.
On the downside, in a GRAT assets transferred to beneficiaries usually do not receive that step-up at death. So, to reduce capital-gains taxes the original article says it may be better to have higher basis assets in the GRAT because those assets will not get (or need) a step-up in basis.
In addition, the original article suggests swapping out low-basis assets that have recorded gains in the trust with high-basis assets, like cash. This swapping can also be implemented with IDGTs that still have their grantor status.
Sound a little tricky?
It is.
Fortunately, an experienced planning attorney can help you sort through this and find the best strategies for your situation.
Remember: “An ounce of prevention is worth a pound of cure.” When making your financial, tax and estate plans, do not go it alone. Be sure to engage competent professional counsel.
Reference: Wall Street Journal (October 29, 2014) "Rethinking Some Grantor Trusts"
